Over the past few years, the global economic turmoil and European debt crisis led investors to a "flight to safety” in the bond market, inflating bond prices in several developed countries and mainly the U.S. However, a shift into equities and other risk-sensitive assets might finally be at hand.
Fed Boosts Equities
The Federal Reserve's attempts to suppress treasury yields and stimulate the economy and the housing market after the 2008 crisis succeeded in channeling capital into equities, triggering a rally that extends to nowadays, as professional investors search for yield in a global zero-interest rate environment despite the higher risk it accompanies in an uncertain global climate.
Still, the post-crisis rally in equities failed to attract the normal retail investor and many other skeptical investors, who remained on the sidelines in anticipation of more clarity over Europe and global growth prospects which kept huge amount of cash on the sidelines. This idea was well supported by the noticeably lower-than-average volume levels during this period.
The steady downtrend in volume levels indicated less contribution in equities, which made many analysts skeptical over the sustainability of the bullish trend, however, markets continued to grind higher, forcing a reconsideration or redefinition of earlier assumptions on the relationship between volume levels and security prices.
Improved Global Outlook, Sentiment
Two main tail risks for the global economy have diminished. First, the euro zone break looks less and less likely, as effort exerted by the European Central Bank (ECB) and European governments succeeded in stamping in their determination to end the crisis.
The ECB has had a major role in lowering bond yields on peripheral countries by implementing three main programs
1) Long term refinancing operations (LTRO) which provided extra liquidity to banks through cheap loans
2) Open Market Operations which promised to conditionally intervene in bond markets in order to suppress yields on troubled countries
3) Boosting ESM to give countries extra liquidity if needed and reducing the default risk
The second risk is a global recession; this has been reduced although it remains a possibility. However, Improvement in United States economic outlook, as signs of recovery in the housing market, improvement in the services sector activities and durable goods orders ultimately resulted in better-than-expected economic growth in the fourth quarter of 2012.
Nevertheless, the recovery remains gradual, in-line with the expected trend within the recent range, and it is not expected to swiftly accelerate in the near term. This would keep the Fed on hold and will compel it to continue injecting money through QE, especially when the government embarks on fiscal tightening over the years ahead as it strives to cut deficit.
China is back on track, the fourth quarter GDP jumped to 7.9 percent, up from 7.4 percent in the third quarter of 2012, fixed asset investments, industrial production and retail sales have been recovering since September, while the new government may start to widen the base of domestic consumption through economic reforms.
Currency Wars
While U.S., Japan, and to a certain extent, the United Kingdom enter the battlefield of currency devaluation in attempts to boost growth and exports, the European Central Bank seems to be heading in the opposite direction, or at least looks rather unconcerned about the currency in the meantime. The European central bank has a priority of bringing back confidence to the zone. On the other hand, the U.S. and Japan adopted an aggressive approach of flooding money into the system, as a weaker currency is mandatory to the health of their economy.
Possible Effect on Asset Classes
Equities
: Given the above assumptions, and if the trend would persist, investors will maintain moving money back into equities, where the latest reports suggested Equity inflows surged to multi-year high. Equities could be the ultimate destination for capital and volume levels to start picking up and moving higher again extending the rally and indices could see new all-time highs over the next medium term.
Although I am constructive on equities, what concerns me is the major euphoria over the current trend in stock prices, as sentiment turned extremely bullish on them, which makes a downside correction possible in the near term, but a correction could be a good opportunity to re-enter at better prices.
Gold: If the economy continues to improve in line with the expected trend, the Fed will come at a step closer to withdrawing money back from the system. And while the government applies fiscal reforms and relative tightening, gold will probably lose grounds to other risky assets as money flows into higher returns. Nevertheless, on the longer run, gold will be the ultimate hedge against inflation when the quantitative easing influence on inflation levels kicks in, triggered by economic recovery.
Euro: I expect the European central bank to start cutting rates in April or May however it would not be sufficient as the Euro may continue to drift higher this year on a diverging and relatively tighter monetary policy.
AUD: Three main reasons why I am bearish on the Australian dollar:
1. In its latest Business Outlook, Deloitte budget advisory group said the mining construction projects, which accounted for much of Australia’s production growth in recent years, will peak earlier than expected later this year, despite government spending cuts making it harder to find a new driver of economic growth. The economy continues to show signs of weakness, with no signal of recovery in the near term.
2. During the recent period, data suggested that investors and central banks diversified their portfolios, adding the Australian dollar as a form of hedge or haven currency, these long positions may unfold as the situation in Europe and U.S. improve in favor to the euro and equities.
3. Further interest rate cuts are likely.